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Madoff \"Red Flags\" Could Have Been Raised by Software

Date: Thursday, January 29, 2009
Author: Tom Cahill, Bloomberg

Banco Santander SA’s hedge fund unit used risk software that according to its developer may have “waved red flags” about Bernard Madoff investments.

“You definitely would have seen it,” Riskdata SA Chief Executive Officer Ingmar Adlerberg said in a phone interview from Paris. Many of the company’s 80 customers have thanked it for flagging risks linked to Madoff, he said. He refused to name them or comment specifically on Santander.

Santander offered on Jan. 27 to pay 1.38 billion euros ($1.8 billion) to private banking clients hit by Madoff-related losses through the bank’s Optimal Investment Services hedge fund arm. Geneva-based Optimal said Riskdata’s FOFiX product was key to “quantitative risk analysis” for hedge fund investments in a 30-page due-diligence questionnaire dated last April.

“Risk profiles are calculated for each hedge fund in order to estimate the systematic factors influencing the returns of the fund,” Optimal said in the document, which was reviewed by Bloomberg News. “Deviation from expected risk profiles need to be explained.”

“Potential breaches of the risk parameters would be immediately notified to the chief operating officer and if appropriate the chief executive officer,” Optimal said in the document.

A Santander spokesman declined to comment on the risk management software or the hedge fund questionnaire.

Class Action Suit

Santander Chairman Emilio Botin, 74, faced repeated questions over the Madoff investments at a Jan. 26 shareholders meeting. The same day, Cremades & Calvo-Sotelo, a Spanish law firm, and U.S. lawyers Labaton & Sucharow LLP filed a class action suit against Santander in Miami, alleging it didn’t do enough due diligence in relation to the alleged Madoff fraud.

The company “acted at all times with due diligence” and “in accordance with all applicable laws,” Santander said in a statement.

Madoff, 70, was arrested on Dec. 11 and charged with using billions of dollars from new investors to pay off older ones in a Ponzi scheme. He told authorities that investors may have lost $50 billion, prosecutors said.

Riskdata’s FOFiX is a tool for fund of hedge fund investors that compares the performance of products with the same strategy to find aberrations in the pattern of results. It also analyzes returns to help explain how a fund made or lost money. The system costs 50,000 euros to 200,000 euros a year.

‘Due Diligence’

When the software sifted through 2,281 comparable funds, it highlighted 20 with “suspicious” performance, including those linked to Madoff and one run by Samuel Israel, Riskdata said. Israel is the founder of hedge fund firm Bayou Group LLC who is accused of faking his own suicide the day he was due to start serving a 20-year sentence for a $400 million fraud.

Red flags the system would have throw up include “returns smoothing,” as well as performance inconsistent with Madoff’s stated strategy, which he described as “split-strike conversion,” Adlerberg said.

Optimal oversaw about $10.4 billion as of April last year, with 76 percent coming from Santander private clients. The Geneva-based investors said in the questionnaire that its hedge fund risk parameters were made in coordination with Santander and any breaches would be reported to the group’s risk monitoring division in Madrid.

“Optimal failed to do due diligence to ascertain the quality of the underlying funds and who was managing them,” said Fernando Luque, an analyst at Morningstar Inc. in Madrid.

Amaranth Lessons

Santander will close seven Optimal hedge funds after the Madoff scandal triggered a surge in withdrawal requests, the bank said Jan. 27. It didn’t disclose the size of the funds or amounts clients had sought to get back.

Santander fell 2.4 percent to 6.36 euros in Madrid trading. The shares have dropped 5.8 percent this year.

Optimal said in the questionnaire that it was “one of a handful of asset managers in the alternative asset space with dedicated resources” in operation due diligence. Its staff of 73 performed due diligence surveys on about 224 managers it invested with as of last April.

Optimal said it bolstered its controls after getting caught with Amaranth Advisors LLC, the Greenwich, Connecticut-based hedge fund that failed in 2006 after losing $6.6 billion.

“Even managers who have historically demonstrated careful risk management over many years can suffer lapses of judgment,” Optimal said in the April document. “In the future we are more likely to take action to cut risk where we believe positions have become too concentrated rather than trusting management to make this decision.”

To contact the reporter on this story: Tom Cahill in London at tcahill@bloomberg.net